The world of indexing has seen explosive growth since the GFC, ushering in a sea change in the way assets are managed. Today, more than 3 million equity indices are being calculated – putting the ratio of calculated indices to listed equities at an astounding 60:1. The ETF market, which is dominated by passive index trackers, has quintupled in size since the GFC, with some forecasts calling for another possible quintupling over the next decade. On the back of this secular shift, the three largest index providers – S&P Dow Jones Indices, MSCI and FTSE Russell – have netted more than a billion dollars in combined revenue in just the first half of this year. What’s behind this sea change? As former Netscape CEO Jim Barksdale once famously said, “There’s only two ways I know of to make money – bundling, and unbundling.”
The business of beta
Prior to the GFC, for every dollar invested with passive U.S. equity managers, there were roughly four dollars of active assets. Whether spurred by disappointing performance of active managers in 2008, the fee and liquidity benefits of ETFs, or the seemingly unstoppable bull market, passive assets make up nearly half the U.S. equity market today. Indices and their passive trackers have given investors efficient access to market beta without the need for an active manager, allowing investors to ‘unbundle’ the return set – disaggregating market beta from idiosyncratic alpha. While some investors raise concerns about what a world driven primarily by passive investing looks like, the trend looks set to continue – some forecasts call for passive assets across asset classes to reach parity by the mid 2020s.
The factor factories
The growth of factor investing (often used synonymously with smart beta) has been no less explosive, with AUM of smart beta ETFs quadrupling over the last 6 years, and showing few signs of slowing. The idea behind factor investing, i.e. allocating to persistent drivers of returns of a similar group of securities, has been studied and implemented for decades, and options for accessing the original Fama French factors (size and value) have existed for investors for some time. More recently, however, more investors have gained efficient access to a range of other factors such as low vol, quality, carry and momentum – this is due in large part to innovation in index products. A rules-based index is an ideal vehicle to capture such factors in an unbiased manner, and further ‘unbundle’ more of the investor return set – this time disaggregating market beta, systematic/alternative beta and idiosyncratic alpha.
As we spelled out in our recent research papers, “What’s in a Name? In the Case of Smart Beta, it’s Hard to Tell Part 1 and Part 2”, creating vehicles to cleanly capture these factors is no trivial task – unintended exposures can easily creep in. The dedicated index team at Axioma uses our proprietary tools and our expertise to help design and maintain factor products that are focused on achieving their objectives.
Back to bundling?
As the number of indices and their wrappers proliferated, so have the use cases of indices – today, indexing has become a solutions business. Indices and their available return streams have expanded the toolkits that investors have for engineering desired outcomes, and have allowed for more focus on the only ‘free lunch’ in investing – diversification. Indices that span asset classes and investment strategies can be used to construct portfolios with objectives such as alpha via a set of factor tilts, or for positioning to capture where we are in the economic cycle. Multi-asset, multi-factor portfolios have become a preferred delivery vehicle for sophisticated investors, with portfolio construction becoming as much of a focus as individual factor design.
The next decade
Ten years on from the GFC, indexing has become an inescapable part of the investment ecosystem. Regulation has followed suit (mainly on the back of the LIBOR scandal), with providers needing to comply with a set of principles set by IOSCO, and benchmark regulation in the EU. This regulation has also driven consolidation in the space, as the infrastructure needed to be a benchmark administrator has grown – this has particularly been the case with index businesses within investment banks. Whether this consolidation continues, or the trend of asset managers ‘self-indexing’ takes hold is an open question in the market today.
More innovation, more ‘unbundling,’ and more ‘bundling’ will surely be on the way, and investors should expect to see more products available that rely on the sophisticated quantitative techniques – which Axioma specializes in. As long as the index industry stays true to what made it so successful – being transparent, rules based and objective – the next ten years should be as exciting for the index space as the last.